Sector

Credit Institutions

Type

Analytical commentary

Assessment of the margin of safety of Russian banks in terms of capital

Prior to the events of this February, the Russian banking sector possessed a rather large margin of safety in terms of capital. The total amount of internal funds in excess of the minimum required (excluding capital buffers) amounted to more than RUB 5.5 tln. The surplus of common equity was a little lower at just over RUB 5 tln. Although this surplus was largely due to the need to comply with regulations, taking into account regulatory capital buffers and increased risk ratios, the level of capitalization was not considered by ACRA to be a potential factor in the overall deterioration of the creditworthiness of Russian banks.

On average, as of February 1, 2022, the 50 largest banks in the Russian Federation in terms of capital had more than 40% more internal funds than the required minimum (excluding capital buffers), and almost 50% more common equity. At the same time, the presence of a capital cushion for systemic importance formed an additional margin of safety, which was possessed by systemically important credit institutions (SICIs).

The risks of asset impairment may be higher than in previous periods of economic deterioration. The events taking place in the economy, which, among other things, are accompanied by a general decline in GDP growth and real disposable incomes of the population, as well as increased risks of rising unemployment, will almost certainly lead to a large-scale decline in the solvency of borrowers in both the corporate and retail segments. Although now, as in 2020, a major restructuring of loans is taking place, which reduces the negative impact of the growth of credit risk on regulatory ratios. ACRA assumes that the total volume of credit losses will have a more serious impact on the creditworthiness of banks than during the pandemic. The reason for this is partly because the situation caused by the pandemic mainly affected small and medium-sized businesses, to whom the state provided considerable support.

One of the key factors is the length of the current downturn over time. The acute phase of the pandemic lasted for a limited period of time, after which the economy started to recover. The duration of the current decline may prevent problem and potential problem borrowers fr om taking full advantage of restructuring. As a result, the risks of bankruptcy, in ACRA’s opinion, are substantially higher.

The situation in the banking sector is also different now due to higher interest rates compared to 2020. In such conditions, even borrowers whose business has proved to be relatively stable may face an increase in interest payments during refinancing, which negatively affects their creditworthiness.

In addition, banks (above all those with state participation) are actively encourage to increase lending, regardless of what impact the economic decline has on borrowers. This may lead to an actual decline of lending standards and growth in credit losses in the future.

Banks are already receiving support to maintain capital adequacy levels. Regulatory easing is providing some support to the ability of banks to get through the current period of economic downturn without a critical burden on capitalization occurring. In particular, at the end of February the accumulated macroprudential capital cushion was released for individual types of consumer loans. As of February 1, 2022, the total volume of risk-weighted assets (RWAs) formed using macroprudential capital buffers amounted to RUB 9.56 tln or 11% of the total credit risk of banks. According to the regulator, this measure helped free-up RUB 733 bln worth of capital (around 5% of common equity).

At the same time, ACRA notes the uneven impact of this measure in terms of the banking system as a whole. According to the Agency’s assessments, more than 60% of this freed-up capital is at Sberbank, Bank VTB and Alfa-Bank, the key retail lenders. Furthermore, these banks are increasing their N1.0 capital adequacy ratio on average by 1 pps amid the disbanding of premiums. For less than half of Russian banks (but for most of SICIs), the positive influence of releasing the capital adequacy ratio cushion exceeded 100 bps.

Besides the suspension of the macroprudential cushion, the Bank of Russia took a number of other (but less significant) steps to ease the calculation of RWAs.

The Bank of Russia’s instruction on the admissibility of non-compliance with to capital adequacy buffers in the current conditions served as an indirect factor supporting the stability of Russian banks in terms of capital adequacy. The amount of excess capital when calculating the ratios, with and without capital buffers, is about RUB 3 tln, according to ACRA. In case of non-compliance with the ratios, banks must develop plans to restore financial stability. This measure does not contain details, but indicates that maintaining a sufficient amount of internal funds or working out the issue of attracting them should remain on the agenda of banks.

Although, as noted above, even taking into account capital buffers, the loss absorption buffer for most banks remains substantial, and for individual credit institutions the possibility of non-compliance with the premiums is a significant mitigating measure in the event of an increase in credit risk.

The ability of banks to offset credit losses through operating profit will remain, but may decline. ACRA notes that on the whole the banking system continues to generate operating profit prior to reserves, despite the influence of certain shocks. Their impact, in particular, the materialization of market and interest rate risk, growth of operating expenses amid inflation and so on, still need to be assessed. Despite this, the financial performance of the banking system prior to reserves for credit losses, according to ACRA’s calculations, will remain positive in 2022. However, the return on equity of banks before the deduction of reserves in any case will not exceed the indicators of 2021 (last year’s results were better than those of 2020). In addition, according to the Bank of Russia, loss of net interest income due to the growth of interest rates will range from RUB 0.3 tln to 0.7 tln. Taking this into account, the volume of reserves that the banking system will be able to cover at the expense of financial results may reach up to RUB 3 tln.

The impact of asset quality deterioration on banks’ capital will be heterogeneous. The margin of safety for the entire banking system looks quite impressive, however, ACRA notes that the adequacy of capital stock to comply with regulatory standards will depend both on the impact of credit risk accepted by each bank on its business model and profitability, and on the share of capital spent on assets subject to credit risk.

ACRA has assessed the impact of potential impairment of banks’ loan books on their ability to comply with capital adequacy ratios both with and without capital buffers. The analysis is based on public information disclosed by the Bank of Russia for 315 credit institutions that complied with capital adequacy ratios as of February 1, 2022. The analysis took into account the ability of banks to generate profit before reserves (without such specific risks of the current situation as securities portfolio revaluation), as well as the impact of the release of the macroprudential capital cushion for RWAs.

In ACRA’s opinion, the sustainability of Russian banks in terms of capital is generally quite high: the analysis showed that, in the event of a 10% depreciation of the loan book, only 17 credit institutions, including two SICIs, failed to comply with the N1.0 ratio excluding the capital buffer and 52 banks, including eight SICIs, failed to comply with the N1.0 ratio including the capital buffer (see Table 1).

Table 1. Relationship between credit losses and capital adequacy compliance1

loan book depreciation

number of banks that may fail to comply with the N1.0 ratio

number of banks that may fail to comply with the N1.0 ratio including capital buffer

Total

Incl. SICIs

Total

Incl. SICIs

< 5%

1

0

12

2

5–10%

16

2

40

6

10–20%

74

8

56

3

20–50%

96

2

84

1

> 50%

128

0

123

0

Source: ACRA


1 In its estimates, ACRA used information to calculate bank ratios in accordance with Instruction 646-P. For each bank, the excess of internal funds was calculated as of February 1, 2022; this excess was adjusted for the amount of credit risk generated as a result of the introduction of macroprudential capital buffers. ACRA also took into account the ability of banks to earn profit before reserves, taking into account data on their formation and release in 2020–2021. The allowable impairment of the portfolio was determined as the ratio of the absorption buffer calculated as described above to the amount of loan exposures.

A key issue in the analysis of the impact of the economic downturn on Russian banks’ ability to meet capital adequacy ratios is, of course, the potential deterioration in asset quality. Despite certain signs of a general deterioration in the quality of loan portfolios of Russian banks, ACRA believes that it will not be possible to estimate the scale of changes until the end of this year. This is partly due, on the one hand, to the prolonged effect of sanctions and their indirect consequences (for example, the withdrawal of large foreign companies from the Russian market), and on the other hand, to the impact of state policies on the economic situation.

Historical data (for the periods of recession in 2008–2009, 2014–2015, and 2020) indicate that, in general, the scale of additional reserves in the banking system did not reach values that could trigger a critical loss of banks’ capital. The most challenging year was 2009 when the cost of risk reached 6%. In the other years indicated, the share of credit losses did not exceed 4%.

In 2020, the amount of additional reserves for the loan book only amounted to 3.8% of its total volume. ACRA believes that, to a large extent, the actual volume of reserves turned out to be lower than the potential due to the positive impact of the restructuring: at the beginning of 2021, ACRA estimated the volume of potential additional reserves at RUB 1.5 tln, which, when added to the volume of reserves created in 2020, resulted in an overall estimate of the cost of credit risk for the loan portfolio of approximately 8.5%.

The system’s need for additional capital may be significant should the total portfolio depreciate by more than 10%. As the current downturn is more severe, total losses (overt and covert) will exceed 10% of the portfolio, with overt losses in the range of 5–10%. In these conditions, at least 17 banks (including two SICIs) may face the need for additional capital to maintain the ratios, and at least 35 more banks (including six SICIs) will be forced to develop measures to strengthen the capital base to meet the standards including capital buffers. At the same time, ACRA notes that if overt losses on the total loan portfolio are in the range of 10–20%, the number of banks that will face the risk of breach of capital adequacy ratios may increase by 74 (including eight SICIs).

The outcome will depend both on the speed of economic recovery and on the success of the restructuring, which, in some perspective, will reduce the amount of reserves. However, the longer the downturn, the closer the amount of losses recognized will approach its actual value because borrowers, even after restructuring, will not be able to restore their creditworthiness in full. Even if the vast majority of banks manage to avoid regulatory violations, the need to comply with capital buffer requirements will require either large capital injections (given that a significant part of the banks at risk of violating regulations with capital buffers is represented by SICIs) or will become a factor of the lower capitalization of the industry in subsequent years.

There are also less obvious negative consequences of capital loss. In addition to the main capital adequacy ratios, banks must comply with a number of other ratios that lim it their credit risks. These include, in particular, concentration ratios (N6, N7, N25). The Bank of Russia has introduced certain reliefs with regard to these ratios, however, these measures are temporary.

Therefore, a number of banks, even having avoided violating the primary ratios, may face the challenge of meeting these “secondary” ratios. In ACRA’s opinion, such risks will be more typical for small and medium-sized banks, especially local ones. As they do not have any options to diversify their loan portfolios, they have to maintain a relatively high loss absorption buffer, which, however, may shrink quickly if a small number of key borrowers default.

Eventually, the total number of banks that will face the need for additional capital to continue their normal operations may considerably exceed the figure given above.

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Analysts

Valeriy Piven
Senior Director - Head of the Financial Institutions Ratings Group
+7 (495) 139 04 93
Svetlana Panicheva
+7 (495) 139 04 80, ext. 169
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